Negative data surprises, elevated fears of a hard landing in China after money market volatility in late June, and expectations of the US Federal Reserve starting to taper the pace of asset purchases culminated in several major emerging market exchange rates falling by 15 per cent or more between May and late August.
The currencies that saw the greatest falls were those with the largest current account deficits, with Brazil, India, Indonesia, Turkey and South Africa attracting the dubious label of the ‘fragile five’.
While the Fed’s surprising decision not to start tapering in September has provided some respite, the sell-off raises the question of whether emerging markets are set for a repeat of the systemic crises witnessed in the 1990s.
The recent volatility follows a period of exceptionally easy global liquidity conditions. The precise extent to which this boosted capital flows to emerging markets is unclear.
Evidence from research is mixed, and total capital flows to emerging markets (as a share of GDP) did not accelerate over the quantitative easing (QE) period. Nevertheless it seems likely that QE has encouraged portfolio inflows (particularly bond flows), which have exceeded the rates seen in the run-up to the global financial crisis.
Against this backdrop, there has been a sizeable widening in external imbalances in some major emerging economies in the past few years.
India, Indonesia and South Africa have all seen a sharp deterioration in current account deficits since the beginning of 2011, and Brazil’s deficit has exceeded 3 per cent for the first time since 2001. Meanwhile, Turkey continues to run a deficit of nearly 7 per cent of GDP.
Buoyant global liquidity has made it easier for emerging market policymakers to allow domestic demand growth to outstrip supply-side potential.
This seems to have been a problem in India and Turkey, and to some extent Brazil. The Indian central bank cut interest rates rapidly in the aftermath of the global financial crisis but was then very slow to raise them. Deeply negative rates through 2010 and 2011 played a big part in entrenching inflation.
In Turkey the monetary policy framework was re-orientated in late 2010 to discourage short-term capital inflows, including a policy of keeping short-term interest rates very low. And while Brazil has kept real policy rates in positive territory, they reached historical lows in early 2013.
Low or negative real emerging market policy rates were easy to sustain in a climate of ongoing QE, without major adverse consequences for exchange rates or domestic asset prices. However, this changed as global financial markets came to anticipate an end to QE following Ben Bernanke’s speech on May 22.
The subsequent 100 basis point rise in US 10-year bond yields coincided with major outflows from emerging market bond and equity funds, and sizeable increases in short-term market interest rates and long-term bond yields.
Brian Coulton is emerging market strategist at Legal & General Investment Management
